Trading options can be enticing.
They can give you more bang for the buck, but they can also burn you as well.
So if you're thinking about trading options, take the time to really know what you're getting into before you make the jump. The following is just a short introduction into the world of options.
Options are derivative instruments, meaning that their values are based on something else. An option to buy Apple shares will be based on the price of Apple's stock.
Options are versatile. You use options for speculation or hedging. And options can be used by themselves, with other options or even with stocks you already own.
There are two kinds of options: calls and puts. A call gives the holder the right, but not the obligation, to buy a stock at a determined price (called the strike price).
A put gives the holder the right, but not the obligation, to sell stock at the strike. Both calls and puts can be bought and sold.
One big draw of options is the amount of leverage involved. You can participate in a stock's movement at a fraction of the cost of owning shares outright.
Take Lululemon Athletica (NASDAQ:LULU - News), which closed Thursday at 73.13. Owning 100 shares would cost $7,313 plus trading commissions. But on Thursday, you could have bought an option expiring June 15, with the right to buy 100 shares of Lululemon at 75 a share for about $435 — 6% of the cost of the stock.
If the stock goes up 37% to 100, your return on the option will be even greater, thanks to leverage.
While this may sound great, know that option prices are affected by not just by the price of the underlying stock.
An option has a limited life expectancy. So the premium, or value of an option, erodes as the date of expiration approaches. If the stock itself doesn't move in a favorable direction by the expiration of your option, you can lose your entire stake.
An option's strike is the price where the option can be exercised at. In the above example, with Lululemon at $75, you can buy an out-of-the-money call to buy the stock at $85. For a call, the higher the exercise price gets above the current price of the stock, generally the cheaper the cost of the option.
Volatility is also a big factor. The higher the volatility, the higher the option price. Interest rates and dividends can also affect option prices, to a lesser extent.
Options also serve as a valuable indicator of investor sentiment.
At the bottom of the "How's The Market?" page, today on B6, check out the Puts Vs. Calls Trading Volume table. This compares the total number of traded puts — which are generally bearish — with bullish calls. A ratio of 1.2 or higher indicates a spike in fear during a big market decline, signaling a bottom may be near.